Turnarounds: How Long is Too Long?

by Will Ashworth | October 25, 2013 9:25 am

Turnarounds: How Long is Too Long?

Meg Whitman has been at the helm of Hewlett-Packard (HPQ[1]) since September 24, 2011, and the company still faces an uncertain future. An article [2]in the IT trade publication Datamation about Ms. Whitman’s turnaround effortshas me wondering how long is too long when it comes to fixing a business.

How long are HPQ shareholders willing to give Whitman to repair the mess she inherited — five years? Six? And what yardstick should be used to measure her performance? Let’s take a closer look at the kinds of things to consider when evaluating the captains who are brought in to save sinking ships.

A Masterful Job

Lou Gerstner’s resuscitation of IBM (IBM[3]) is probably one of the most talked-about events in U.S. corporate history. In his book Who Says Elephants Can’t Dance, Gerstner estimated Big Blue’s corporate culture would take five years to change. You could argue that when he retired in December 2002 after almost 10 years at the firm it was still undergoing transformation.

But what you can’t argue against is that he left IBM in much better shape than he found it — which should be the goal of every CEO, not just the ones providing first aid. At the end of the day, IBM shareholders were rewarded with an annualized total return of 22% during Gerstner’s tenure. Since then its annual total return’s averaged a modest 9.5%. Clearly, shareholder return is an important component when evaluating a turnaround’s success, but it’s not the only factor.

Good Things Take Time

Sometimes investors simply don’t see what’s keeping the stock down despite obvious signs of recovery. Take Apple (AAPL[4]) for example. Steve Jobs came in as “interim” CEO in September 1997, returning to the company he co-founded after a 12-year absence. In fiscal 1996 (September year-end), Apple lost $816 million on $9.8 billion in revenue. Jobs and the board implemented a major restructuring over the next two years that would significantly reduce the company’s expense structure. Included in the cost cutting were major job cuts.

However, it’s the non-personnel-related decisions that helped build the foundation of what’s become a great product innovator. The first was to end its licensing of the MAC operating system to other personal computer vendors. That made its operating system exclusive to Apple products, avoiding the me-too cloning of PCs and the subsequent decline in prices. The other was to increase the amount of outsourced manufacturing it used to build its products. Focusing on design and marketing, the move paved the way for its first major innovation — the iPod — in 2001.

Apple hit a revenue bottom of $5.94 billion in fiscal 1998, approximately $4 billion less than the year before Jobs took over. Nonetheless, it managed to earn $309 million. Jobs had learned the trick of any good turnaround: It doesn’t matter what kind of products you make if you don’t make money. That major shift in Jobs’ thinking was a godsend for Apple.

The company’s net profit grew to $786 million in fiscal 2000, and after rocketing up nearly 500% in Jobs’ first three years at the helm, the stock cooled back down to a 138% return. That’s market-beating performance, but other CEOs have managed to do even better in shorter time frames: Best Buy’s (BBY[5]) CEO, Hubert Joly, has been in charge for just 14 months and its stock’s up 150% through October 23 — more than quadrupling the S&P 500 in that time.

What’s the Takeaway?

Evaluating a company solely by stock performance cuts both ways. More important than the stock price is what’s being done to alter the company’s direction. Creating a sensible plan that realistically can work and then successfully executing it is what matters most — simple in theory, but far from easy.

Looking at the Hewlett-Packard situation, Whitman’s five-year plan appears to be working. In my opinion, five years is an unusually lengthy period of time given today’s business climate; however, you’ve got to look at where it was before Whitman took over to where it is today in order to understand why she deserves more time. Whitman’s plan was to take the first two years to stabilize the company, get it on better financial footing, and then kickstart its growth in 2014 and beyond.

In the last year HPQ has reduced its net debt by almost $8 billion and will finish fiscal 2013 with $8 billion in free cash flow. That’s a free cash flow yield of 17.4%, compared to 7.5% for IBM. At current prices, it could reduce its share count by 17% if it used all $8 billion to buy back its stock. It won’t, but it illustrates how much stronger it has become financially compared to two years ago. Like Jobs before her, it appears Whitman is getting HPQ profitable before preparing to blow off the doors with revenue.

Seeking Alpha contributor Paul Franke does a good job explaining why HPQ has become the best deep-value play[6] in technology. He cites the fact Whitman has cut costs, stabilized its day-to-day business and figured out which businesses are worth growing and those that aren’t. In 2013, it has cut $3 billion in annual expenses from its income statement and brought its costs in line with sales. The company now has the chance grow sales while maintaining stronger margins and overall profitability. To that end, Franke believes $4 per share in earnings is possible by 2014. That would make HPQ dirt cheap at $24.

Bottom Line

Every turnaround is different.

Some, like Hewlett-Packard’s, are clearly more complicated than others. Forget the stock price when buying into a turnaround and instead focus on the CEO’s plan. Not everything is going to be executed immediately, nor is everything going to be a home-run success. All you really want to see are enough singles and doubles in each quarterly report to demonstrate that the company hasn’t forgotten the urgency.

If you’re Meg Whitman, 2014 is your year of reckoning. By the end of next year (Q3 and Q4) it must begin to show some revenue growth. If not, I’d move on.

Three years should be plenty of time in most cases. Anything more and you’re spinning your wheels.

As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.